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The market was hit hard from all directions today. Major company
reports indicated more economic weakness ahead at the same time
that an imminent tapering of QE became more imminent. The
ten-year bond rate took another leap higher in response to lower
unemployment claims despite WalMart and Cisco joining Macy’s in
forecasting lower revenues in the second half. This was enough to
cause the market to plunge down through its near-term S&P 500
support of 1676 on volume that, although still low, was solidly
higher than the previous day. It is now likely that the market
has begun a new major down leg. We cite the following factors,
many which have been around for a while, that now seem to be
coming to a head.

The 10-year rate has jumped from 1.6% to 2.8% within a
relatively short period of time in response to the prospect of
Fed tapering, indicating that the bond market caught on to its
negative implications quickly while stocks have been slow to
react until very recently. The interest rate rise has increased
mortgage rates significantly and will impact consumer borrowing
rates for durable goods such as autos.

Asset values such as stocks and real estate have become
increasingly dependent on QE for growth in the absence of a
self-sustaining economic recovery. With earnings growth having
leveled off, the seemingly open-ended QE has been virtually the
only factor holding up the market. The market similarly soared
during QE1 and QE2, and corrected after they ended, only to be
bailed out by QE3 and QE4, which deliberately had no definitive
ending date. Now that the ending date of QE4 is no longer
infinite, the market is likely to act as it did in anticipating
the end of the prior QE programs.

Even with QE in effect with no known ending date, economic growth
remained stuck at an inadequate 2% on average, and has not been
picking up. Consumer spending, accounting for about 70% of GDP,
has been hampered by deleveraging as well as barely growing
disposable income. Reports by WalMart, Cisco, Macy’s and others
indicate that forecasts for a second half pickup in growth are
highly doubtful. Auto sales returned to pre-recession levels by
last November, but since then have been about flat. Housing
appears to have stalled since the 10-year rate started to rise.
Single-family housing starts have declined over the last three
months while MBA purchase applications have dropped to the lowest
level of the year as the rise in home prices and mortgage rates
have led to a sharp rise in prospective monthly payments.

The Fed’s desire to taper QE is therefore not being spurred by a
stronger self-sustaining economy. From minutes of the FOMC
meetings, Bernanke’s press conference and various speeches by Fed
members, it seems apparent that they are concerned QE is becoming
less and less effective with the passage of time and that the
potential negative side effects are increasing. While the goal
has been to raise asset values by enough to have the so-called
wealth effect spread to the economy, it has not happened, and
they are increasingly worried about how they are eventually going
to pare down the Fed’s balance sheet that has soared to unheard
of levels.

Adding to the problem is the coming clash in Washington over the
Federal budget and debt ceiling, with a strong faction of the
House talking about closing down the Federal government. Although
it probably won’t happen, the fight will be accompanied by a lot
of intense conflict, political posturing and scary headlines that
investors won’t like.

The steep market rise since March 2009 is long in the tooth and
valuations have been stretched to highs that equal every major
market top since 1929 with the exception of the bubble highs in
2000 and 2007. Similar to the 2000 dot-com peak and the 2007
housing boom peak, the current market is based on the QE bubble
rather than the economy.

Technically, when the market broke above its previous high
of 1687 on the S&P 500, it stopped at 1709 and has since
broken down into its previous zone, negating the validity of the
breakout. Notably, average daily new highs on the most recent top
were only about 400, compared to 800 on the prior peak,
indicating deterioration in market action. In addition, as we
mentioned above, today’s downward move broke down through a key
short-term resistance point. In sum, we believe that this is the
probable start of a major down leg in the market.